When Is A Prepayment Penalty Worthwhile?

by Peter G. Miller
October 17th, 2007

I came across a really good explanation of prepayment penalties by Morgan Brown, a California mortgage lender who operates BlownMortgage.com.

For FHA borrowers prepayment penalties are not an issue — they’re not allowed. But in the untamed private sector, you can pay big money when lenders slip in a prepayment penalty.

Morgan has a plain-language discussion of prepayment penalties and generally concludes that they are something to be avoided. While I agree with Morgan’s general conclusion, I would take a different view regarding two issues.

First, while it’s true that prepayment penalties are banned in many jurisdictions under state law, state laws do not apply to federally regulated lenders. Thus, in my state of Maryland our rules say that prepayment counties are banned. Still we have prepayment penalties because loans here are being made by federally regulated banks, thrifts, and credit unions.

Second, I am not convinced that borrowers are always getting a discount in exchange for prepayment penalty because borrowers have little idea regarding how loans are priced.

As the National Association of Realtors has said, “prepayment penalties often trap borrowers in loans they cannot afford by making them too expensive to refinance. While some lenders may, in fact, offer lower rates in exchange for a borrower agreeing to a prepayment penalty, in the experience of many Realtors, that option is not typical. A 2005 study by the Center for Responsible Lending concluded that borrowers with subprime loans and prepayment penalties do not receive lower interest rates, and may actually pay higher rates.”

To me, prepayment penalties are never attractive except in one situation: If the lender has put cash on the table to lower your closing costs than it seems fair that the lender should have some opportunity to recover its expense. Two years seems about right.

Still, take a look at Morgan’s comments, he’s got something worth reading.

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This entry was posted on Wednesday, October 17th, 2007 at 12:46 pm and is filed under , . You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

2 Responses to “When Is A Prepayment Penalty Worthwhile?”

  1. Chad Rupert Says:

    I have a question regarding prepayment penalties on a mortgage loan within my state of Pennsylvania! My wife and I have a sub-prime loan. This first lender is now out of business! When we got this loan, we were told we wouldn’t be able to get a loan ANYWHERE else for less than they were offering! I had a fixed rate before this at 5.75% and we ended up getting an ARM with a 7.9% interest rate for 3 years. Our adjustable rate period ends in February, 2009! My BIG question is we wanted a fixed rate loan and they couldn’t give us that! Instead we have an ARM with a prepayment penalty equal to 6 months interest! Is this illegal in the state of Pennsylvania to charge a prepayment penalty if we find a mortgage company thats willing to give us a FIXED rate! Our monthly payment is KILLING us! I heard that companies in your state can’t charge you interest BUT companies whose headquarters are in another state could charge you the penalty? I’m just confused with all the technical mortgage jargon! If you could provide me with ANY information, it would be greatly appreciated! I’m astonished with the amount of forclosures happening and the financial companies writing off BILLIONS due to this SUB-PRIME mess! The last thing my family wants to do is be forced to sell our home or worse forclose because we can’y afford to pay! Thanks for your time!!

  2. Kevin Fisher Says:

    Great post, thank you for the insight.

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